Although families can cover the cost of college with student and parent loans, it is less expensive to save for college in advance. Saving money in a 529 college savings plan also provides flexibility in college choice in addition to reducing the need to borrow.
The total cost of repaying a loan often exceeds the total contributions to a college savings plan. You save money by avoiding the need to pay interest on the loans.
For example, suppose you save $250 per month for 17 years at a 4% average annual return on investment. You would accumulate a total of $73,116, with 30% of the total coming from earnings and $51,000 from contributions.
If, instead of saving this money, you borrowed $73,116 in Federal Parent PLUS loans at 7% interest with 4% fees added to the loan balance and a 10-year repayment term, you’d pay a total of $106,117, more than twice the total contributions. You’d also pay $884 per month.
Even if the repayment term were increased to 17 years, the monthly payment would be $640, more than double the amount contributed per month, and the total payments would be $130,459.
Tax benefits like the student loan interest deduction can reduce the cost of student loan debt, but it is still cheaper to save than to borrow.
The difference is that when you save, you earn the interest, but when you borrow, you pay the interest. The power of compound interest works in your favor when you save and works against you when you borrow.
Obviously, if the interest rate on debt is lower than the interest rate on savings, one could engage in arbitrage by borrowing to the limit and investing the proceeds, leveraging the spread between the return on investment and the cost of funds.
Although it is best to start saving when the child is young, when time is your greatest asset, it is worthwhile to save even when college enrollment is imminent. Every dollar you save is a dollar less you’ll have to borrow. Every dollar you borrow will cost about two dollars by the time you repay the debt, given the typical mix of interest rates and repayment terms. By saving money, you will literally save money.
Mark Kantrowitz is a nationally-recognized expert on student financial aid, scholarships and student loans. His mission is to deliver practical information, advice and tools to students and their families so they can make informed decisions about planning and paying for college.
Mark writes extensively about student financial aid policy. He has testified before Congress and federal/state agencies about student aid on several occasions.
Mark has been quoted in more than 10,000 newspaper and magazine articles. He has written for the New York Times, Wall Street Journal, Washington Post, Reuters, Huffington Post, U.S. News & World Report, Money Magazine, Bottom Line/Personal, Forbes, Newsweek and Time Magazine. He was named a Money Hero by Money Magazine. He is the author of five bestselling books about scholarships and financial aid, including How to Appeal for More College Financial Aid, Twisdoms about Paying for College, Filing the FAFSA and Secrets to Winning a Scholarship.
Mark serves on the editorial board of the Journal of Student Financial Aid and the editorial advisory board of Bottom Line/Personal (a Boardroom, Inc. publication). He is also a member of the board of trustees of the Center for Excellence in Education. Mark previously served as a member of the board of directors of the National Scholarship Providers Association.
Mark is currently Publisher of PrivateStudentLoans.guru, a web site that provides students with smart borrowing tips about private student loans. Mark has served previously as publisher of the Cappex.com, Edvisors, Fastweb and FinAid web sites. He has previously been employed at Just Research, the MIT Artificial Intelligence Laboratory, Bitstream Inc. and the Planning Research Corporation.
Mark is President of Cerebly, Inc. (formerly MK Consulting, Inc.), a consulting firm focused on computer science, artificial intelligence, and statistical and policy analysis.
Mark is ABD on a PhD in computer science from Carnegie Mellon University (CMU). He has Bachelor of Science degrees in mathematics and philosophy from MIT and a Master of Science degree in computer science from CMU. He is also an alumnus of the Research Science Institute program established by Admiral H. G. Rickover.
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